First deal - High leverage?

2 Replies

I'm looking into purchasing a commercial lot that is a corner lot on a state highway in a tourist region of NY. The seller is very motivated and willing to finance and I would like to offer what I can afford - 5% down. The property has a very small office building and a couple of manufactured homes on it right now, so its income can cover expenses and mortgage debt as is, but it is being marketed as redevelopment land. The idea would basically be to let it pay for itself until I either find a big box interested in the location (quite a few have built in the area in recent years) or raise money from partners to finance its development into a bigger retail/mixed use space. I expect to have funds available in a year or two to put $100k+ into financing development, as well.

Oh, and it's also not very close to where I live. About 2.5 hour drive.

Being new to real estate - am I getting myself in over my head? I do have a good relationship with the broker, who is an experienced commercial developer and offered to help me with property and project management after I purchase.

Tips, encouragement and/or warnings of doom would be appreciated ;-)

First of all, high leverage isn't a problem on its own.  The problems is that many people buy properties using not only high leverage, but also at the peak of the market, and also when the property isn't such a great deal (a property not being acquired at a significant discount of market value).  

We seem to be at the peak of the market now, so unless the property is a very good deal, it probably wouldn't make sense to borrow 95% of the purchase price, especially if you'll be personally guaranteeing the loan.  

There are tens of millions of commercial properties throughout the country that you shouldn't need to settle for a deal that is anything less than spectacular, especially if its your first deal and you don't have much cash.  Especially since you're writing that you expect to have $100,000 within the next year, I would recommend to be very patient and cautious for the next year or two now that we seem to be at the peak of the market.  If this was 2009/2010 my advice might be different, but most experts agree that we're at or near the peak of the market.

Also, a good question to ask yourself when analyzing a property is "Is there anything I can do to this property immediately to add 20-50% of value to the property over and above what I'm paying for it?" (renting, raising rents, thinking about the property in a different way/use, etc.)  Why rely on market trends or a potential development opportunity, when there are so many properties where you're able to take things into your own hands and add immediate value?

Here are some questions to help you determine if the deal is good enough:

  • Are you able to do anything to the property for it to earn a 10+ cap on the property, so that even if the development plan doesn't end up happening, the property will still be a decent cash flow investment? (raising rents, adding a billboard, etc.)
  • What type of seller are you acquiring the property from? (experienced investor, someone who inherited the property, a distressed seller)  When did that seller acquire the property? If the seller is an experienced real estate investor or if the seller acquired the property within the past few years and is looking to flip it, it might be a good idea to be extra careful.  
  • Are you acquiring the property below land value (or at least not above land value)?  If not, I would probably walk away.  In development, you can't have your cake (existing property) and eat it too.  You either can price the property based on its current use or development potential.
  • Is the property being widely marketed on Loopnet?  If so, then it probably isn't such a great deal. If it were a great deal and the seller was offering 95% financing, it would likely sell very quickly.  

Let me know your thoughts and if you have any other questions/thoughts.  Good luck!

-Josh

Hi Josh, thanks for your awesome answer. The property is being marketed and priced for redevelopment, with the current income as a perk. Based on current income, it is at a 4% cap rate. For some reason I hadn't actually thought of looking for it on LoopNet, where it is indeed being marketed - but the asking price is $1.3 million. When I talked to the broker about offering $900,000 she said I should put in the offer because it's been on the market a while and they need to sell. That itself would get the cap up to 5.72%, and if I raise rents to market and fill a couple vacancies I think it would go up to 7%. Billboard is an interesting thought, but I'm not sure that would add significantly to the income. To get a higher return would require either making additions to the current building or redeveloping the whole lot.

So, in answer to your first bullet point, there's really nothing I can see to get it up to 10% without sinking a good amount more cash into it.

The seller is an older gentleman who apparently owns a lot of commercial property up there, so yes, and experienced investor. I was told he is motivated. He is not necessarily offering 95%, he is offering to carry the note and my thought was to see if he would accept 95%.

As far as land value, interesting point. Just looking on Zillow I see a couple miles up the road a 7+ acre vacant lot zoned commercial with 500+feet of frontage on the same highway for $400k. So, a lot more space for a lot less money, although the location might not be quite as good, which of course can have a big effect on value. So although I'm not familiar enough with the area it does seem that it may be somewhat overpriced as empty land.

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